Download I. Market Failures and Knowledge Economists argue that general

I. Market Failures and Knowledge
Economists argue that general market failures for knowledge occur with indivisibilities,
uncertainty, and public goods. Market failures for indivisibilities occur because marginal
cost pricing is difficult to accurately accomplish and knowledge in general requires a
large fixed cost. The price of knowledge must be set high enough to cover fixed costs but
then the product created from the knowledge is unreasonably high. Think of how
expensive new drugs are when they are first released on the market. This is because the
cost of hiring chemists with the knowledge needed to develop the new drug, as well as
the facilities and high-tech tools, must be recovered by setting a high price on the drug. In
addition, knowledge can be expensive if one factors patents into the formula. Some
companies may need to pay a licensing fee for using a particular technique or compound
when developing or producing their product because another firm has a patent on a
process which the company needs to use. For this reason, some innovative research may
not be undertaken because the cost to the firm is higher than the private benefits that can
be recovered. Next, there are market failures with how markets deal with uncertainty
because of moral hazard. When a particular research project fails, for instance, it is
sometimes hard to decipher why the project failed. There are many external factors that
must be taken into consideration, such as personal motivation, the economy, politics and
randomness, and these factors are very hard to test and account for. This can effect
innovative research because if a firm perceives that a project failed due to an incorrect
factor, say a firm thinks a project failed because of the nature of the research and it was
actually due to the person carrying out the research, the firm may decide to discontinue
R&D in that area. By deciding to cease researching in that area, the public suffers
because they will not reap the benefits had the research continued. Last, public goods
account for market failure because too little research may be done in areas where the
public benefits. For example, a firm will not do research that has a high social rate of
return but a low private rate of return. Economic incentives are more important to private
industries and therefore the government steps in to promote research in the areas that are
beneficial to the public but are not undertaken by private firms. Another example is the
problem with free riders. When the government provides benefits for conducting research
and firms carry out R&D that they would have done even without the benefit, the public
suffers by paying for the research through their taxes (that would have been done by the
firms regardless) and by losing out on new research that could haven been done if the
government put that money into any area where free-ridership would not occur.
Due to the above mentioned market failures, the government sometimes steps in
by regulating intellectual property rights, giving direct subsidies for R&D, and R&D tax
credits. By regulating intellectual property rights, through the use of patents, the
government is able to promote R&D. Allowing patents creates incentives for firms to
carry out research because the patent will allow them to have sole rights over that process
or new knowledge for a period long enough to recover the costs of their research as well
as a period of time where they will receive economic profits. For firms, patents are
necessary to continue their research. This type of government intervention method is very
effective because whoever gets rights to the patent will surely receive large economic
profits from their innovation. On the other hand, it can stifle innovation by limiting the
flow of knowledge. For instance, if a computer company would like to develop a new
product to help the handicapped but can not apply a necessary process to their design
because it is held as a patent by another firm, the research will never be done and the
product will never be created. In this way, patents can inhibit innovation. As we
discussed in class, there are many pros and cons, and due to the rapid increase in
knowledge and R&D in this “information age” it is too soon to tell what effect dominates.
The next way the government intervenes is through subsidies. Subsidies are a very
effective method for the government to promote a R&D for a specific area of research.
The government can stipulate what it wants done and get exactly what it wants because it
is giving the subsidy. For instance, the government may subsidize stem cell research (and
that kind of research will produce specific results desired by the government that may
have positive spillover effects in society), or it can subsidize nuclear energy research
which would not be done in the private sector because the government is the only
consumer. Last, the government can use R&D tax credits. Tax credits help stimulate
R&D by lowering the costs of research. This encourages firms to pursue certain types of
R&D (depending on what kind of research the tax credit is for) that would otherwise not
be done due to financial constraints. A downfall here is that there may, again, be free
riders. Some firms may have carried out the research with or without the tax credit.
Therefore, the government needs to be careful to choose tax credits on types of research
that produce substantial social benefits which would otherwise not be produced due to the
high cost or other barriers to conducting that kind of research. Firms are still concerned
with private returns, so the tax credit needs to be large enough to encourage firms to do
the research, usually between 15%-20%, but the tax credits should not be so high that the
cost outweighs the social benefits reaped from the R&D.
This is a strong answer that raises some important points, but there are a couple of
possibilities for improvement. One thing that the author does well is provide clear
examples of how economic concepts apply in the real world. A good example of this is
on page one, where the author writes:
“The price of knowledge must be set high enough to cover fixed costs but then the
product created from the knowledge is unreasonably high. Think of how expensive new
drugs are when they are first released on the market. This is because the cost of hiring
chemists with the knowledge needed to develop the new drug, as well as the facilities
and high-tech tools, must be recovered by setting a high price on the drug.”
In general, the answer needs more organization to make it easier for the reader to
follow. Shorter, more direct paragraphs would help illustrate each key point to the
reader. For example, each of the market failures discussed in the first paragraph
could be presented in a separate paragraph. A stronger introduction with a more
general explanation of market failures could help to tie these paragraphs together.
Also, some more details about what types of projects tax credits and subsidies are more
or less likely to subsidize would help.